Understanding Basel Norms And Their Implications

We often come across terms like Basel Norms or even phrases like "XYZ bank has been fined a certain amount for not maintaining the required capital adequacy ratio and thereby violating the Basel Regulations". But, have we ever thought why such norms were introduced? Why are banks mandated by RBI, in India, to adhere to the same? Why is the recent PCA introduced by the RBI in 2017 linked with this norm? Let us explore the BASEL NORMS and the answers to these questions in the subsequent paragraphs.

Banks are the financial institutions that serve as an intermediary between the lenders and the borrowers and therefore in the process of converting the deposits - liabilities, into loans - assets, the banks face risks of two types, liquidity risk and solvency risk. Liquidity risks are those risks which banks face when they are short of meeting short term demands. For example, Mr. X deposits 1 lakh rupees in his account and he goes the next day to withdraw the same. If the bank is unable to pay back the same amount to Mr.X, in that case, the bank will not be liquid. The reason for the same could be that the bank had invested the money in an asset which it cannot sell and hence it(asset) is not liquid and the risk due to this situation is known as liquidity risk. So liquidity is essentially short term in nature. Contrarily, the ability of the bank to payback Mr.X in the long term is called as Solvency Risk.

Now banks mitigate these risks in the following ways:

• Liquidity Risk: They need liquid assets to mitigate this.
• Solvency Risk: They need capital to mitigate solvency risk so that losses for degraded asset quality do not erode depositor’s money.

Basel, a city in Switzerland, is the headquarters of the Bureau of International Settlement (BIS), the organization of central banks of the world. Basel Committee was formed in 1974 as a regulatory committee to maintain financial stability across the banking institutions in the world. It was established by the Central Bank Governors of the Group of Ten countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets (notably the failure of Bankhaus Herstatt in West Germany). The Committee suggested a set of international standards for bank regulation, most notably its landmark publications of the accords on capital adequacy which are commonly known as Basel I, Basel II and, most recently, Basel III. The primary activity of the committee so formed was to bridge the gaps in international supervisory coverage so that (i) no bank would escape supervision, and (ii) supervision would be adequate and consistent across members involved. Thus, the committee so formed came up with a set of guidelines namely Basel I, Basel II and Basel III.

Basel I - 1988

• The focus of this norm was on credit risk.
• Capital and structure of risk weights for banks were laid down.
• The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA) by the end of 1992.
• India adopted Basel 1 guidelines in 1999.

With time the needs of the banking system do change and therefore the BASEL committee also updates the norms to suit the needs of changing times.

Basel II - 2004

This accord was based on three pillars which are given below:

• Minimum capital requirements, which sought to develop and expand the standardized rules set out in the 1988 Accord.
• Supervisory review of an institution’s capital adequacy and internal assessment process.
• Effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices.

This framework was designed to improve the way regulatory capital requirements reflect underlying risks and to better address the financial innovation that had occurred in recent years.

Basel III - 2010

Basel regulations published so far focused on the granulation of risks and therefore a system was required that would focus on the financial system as a whole and not on the individual granularities. This didn’t help much in preventing the collapse of banks like Lehman Brothers. So this accord was framed to ensure that the Banking sector is shockproof from the various economic and geopolitical shocks to the Banking system. Thus, Basel III was formed after the recession of 2009 to regulate the financial sector as a whole and not just the individual elements.

The major propositions of BASEL III were:

• Counter-cyclical buffers to mitigate the risks of credit and assets turning stale.
• Better capital quality to meet financial risks.
• Leverage and liquidity ratios were to be maintained at a safe level as directed.
• Common equity has to be at least 4.5% of total risk-weighted assets.
• The minimum total capital requirement was maintained at the current 8% level(9% for Indian PSUs).
• The total capital has to be at least 10.5% when combined with the conservation buffer.

Thus Basel III takes care of the entire banking system, thereby cushioning against the shocks that can arise in the system. India is a member of G20 countries and since BASEL regulations are mandated for G20 countries, RBI adopted BASEL III norms for the banks and therefore it is mandatory for the banks to meet the BASEL norms or else they get penalised. This ensures that the Indian Banking system is resilient enough from the systemic shocks.